Fundamental Analysis Lec2-Investment Managment And Portfolio-Lecture Notes, Study notes of Investment Management and Portfolio Theory

Download Fundamental Analysis Lec2-Investment Managment And Portfolio-Lecture Notes and more Study notes Investment Management and Portfolio Theory in PDF only on Docsity! y g ( ) Lesson # 12 FUNDAMENTAL ANALYSIS Contd… Ratio Analysis: Financial ratio analysis is a fascinating topic to study because it can teach us so much about accounts and businesses. When we use ratio analysis we can work out how profitable a business is, we can tell if it has enough money to pay its bills and we can even tell whether its shareholders should be happy. Ratio analysis can also help us to check whether a business is doing better this year than it was last year; and it can tell us if our business is doing better or worse than other businesses doing and selling the same things. In addition to ratio analysis being part of an accounting and business studies syllabus, it is a very useful thing to know anyway. The overall layout of this section is as follows: We will begin by asking the question, what do we want ratio analysis to tell us? Then, what will we try to do with it? This is the most important question. The answer to that question then means we need to make a list of all of the ratios we might use: we will list them and give the formula for each of them. Once we have discovered all of the ratios that we can use we need to know how to use them, who might use them and what for and how will it help them to answer the question we asked at the beginning? At this stage we will have an overall picture of what ratio analysis is, who uses it and the ratios they need to be able to use it. All that's left to do then is to use the ratios; and we will do that step- by-step, one by one. By the end of this section we will have used every ratio several times and we will be experts at using and understanding what they tell us. LIQUIDITY RATIOS: 1. The Current Ratio: The current ratio is also known as the working capital ratio and is normally presented as a real ratio. The formula to calculate the current ratio is; Current Ratio = Current Assets / Current Liabilities The ratio is mainly used to give an idea of the company's ability to pay back its short-term liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The higher the current ratio, the more capable the company is of paying its obligations. A ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that point. While this shows the company is not in good financial health, it does not necessarily mean that it will go bankrupt - as there are many ways to access financing – but it is definitely not a good sign. The current ratio can give a sense of the efficiency of a company's operating cycle or its ability to turn its product into cash. Companies that have trouble getting paid on their receivables or have long inventory turnover can run into liquidity problems because they are docsity.com y g ( ) unable to alleviate their obligations. Because business operations differ in each industry, it is always more useful to compare companies within the same industry. This ratio is similar to the acid-test ratio except that the acid-test ratio does not include inventory and prepaid as assets that can be liquidated. The components of current ratio (current assets and current liabilities) can be used to derive working capital (difference between current assets and current liabilities). Working capital is frequently used to derive the working capital ratio, which is working capital as a ratio of sales. The working capital means the amount that current assets exceed the current liabilities. In simple words, it is the difference current assets and current liabilities. Working Capital = Current Assets – Current Liabilities Positive working capital means that the company is able to pay off its short-term liabilities. Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets (cash, accounts receivable and inventory). 2. The Acid Test Ratio: The acid test ratio is also known as the liquid or the quick ratio. The idea behind this ratio is that stocks are sometimes a problem because they can be difficult to sell or use. That is, even though a supermarket has thousands of people walking through its doors every day, there are still items on its shelves that don't sell as quickly as the supermarket would like. Similarly, there are some items that will sell very well. Nevertheless, there are some businesses whose stocks will sell or be used slowly and if those businesses needed to sell some of their stocks to try to cover an emergency, they would be disappointed. Engineering companies can have their materials in stock for as much as 9 months to a year; a greengrocer should have his stocks for no longer than 4 or 5 days - a good greengrocer anyway. We'll look at the acid test ratio; Acid Test Ratio = (Current Assets - Inventory) / Current Liabilities PROFITABILITY RATIOS: 1. Gross Profit Margin: Gross Profit Margin = Gross Profit / Net Sales * 100 Remember; Gross Profit = Sales – Cost of Goods Sold The gross profit margin ratio tells us the profit a business makes on its cost of sales, or cost of goods sold. It is a very simple idea and it tells us how much gross profit per Rs. 1 of turnover our business is earning. Gross profit is the profit we earn before we take off any administration costs, selling costs and so on. So we should have a much higher gross profit margin than net profit margin. docsity.com